Should you invest in rental real estate?
If you want to make a
profit by investing in rental real estate, you must be willing to commit more
resources to this property than you would to an investment made at your bank,
through a broker, or in a mutual fund.
Someone has to collect
rents, find good tenants, and maintain the property. If you hire help to do
these tasks, your profits shrink.
Also, if you borrow
money to buy the property, you have to pay the mortgage whether or not the
property is rented. You should have emergency funds so that you will not lose
the property to foreclosure if you lose your tenant.
If you decide to
invest in rental property, you may need professional help to match your
resources to property that will meet your goals. Some of the questions you
should consider before you invest:
·
What can you afford?
Determine the highest price range you can sustain, given your present resources
and the projected cash flow from the property.
·
Is the property fairly priced?
Get a list of comparable listings and recent sales from a real estate company.
Make any purchase offer contingent on the results of structural and pest
inspections. Check local records to verify that additions and major
improvements were made in compliance with building codes.
·
Are there any restrictions on the property?
Rent control will lower the price that you can afford to pay for a property.
·
Who will be your tenants?
Evaluate the likelihood of non-payers, transients, and untidy housekeepers and
adjust your price accordingly. If you are buying a condominium in a building
populated with young people, you may find it difficult to interest a retired
couple (if that's your market) in living in the unit.
Investing in rental
property can be very profitable, but you should be fully informed before you
invest, or you could end up with more work and less return than you
anticipated.
How to calculate cash flow from rental property
Now that real estate
tax breaks have been cut significantly, it's more important than ever to see
good economic reasons for owning rental property. Here's how to calculate the
cash flow from an investment in rental property.
First, calculate
taxable income or loss from the property. Taxable income or loss is rent received
minus three types of expenses: operating expense, depreciation, and mortgage
interest expense.
Assume the purchase of
a single-family house for $125,000, of which $25,000 applies to the land and
$100,000 to the building. Depreciation of the cost of the building is a tax
deduction even though depreciation is not paid out in cash each year. However,
the deduction must be spread over 27.5 years. Divide the $100,000 cost of the
building by 27.5 years. Your depreciation expense is $3,636 per year.
Assume a cash down
payment of $30,000 and a mortgage loan of $95,000 for 25 years at 10%. The
first year's payments would be $10,359 including about $9,459 of tax-deductible
interest.
Suppose the property
is rented for $12,000 a year, and the total of operating expenses paid by the
owner, such as property tax, insurance, and repairs, is $2,500. Subtract from
rental income of $12,000 the three types of expense: depreciation ($3,636),
interest expense ($9,459), and operating expense ($2,500). The result, for tax
purposes, is a rental loss of $3,595.
The tax rules on
rental losses are different if you're a real estate professional. But if you're
not a professional, here's how your rental loss could affect your income tax.
If you actively manage
the property and your adjusted gross income does not exceed $100,000, the
rental loss (up to a maximum of $25,000) could be deducted from other income
such as salary, interest, and dividends. Multiply the rental loss by your
federal income tax rate (in our example, 31%). The federal tax avoided as a
result of this deductible rental loss is $1,114.
|
Rental income |
|
$12,000 |
|
Plus: Tax savings |
+ |
1,114 |
|
Less: Operating expense |
- |
2,500 |
|
Less: Mortgage payments |
- |
10,359 |
|
CASH FLOW |
+ |
$255 |
The investment just
about "breaks even" on cash flow. The owner's equity in the property
increases each year as the mortgage loan is paid down. Any increase in the
value of the property during the years of ownership will increase the owner's
ultimate return. The owner's ultimate return on the property will be affected
by any taxes paid on the gain when sold.
Calculating the cash
flow on a rental property investment you're considering will help you decide
whether the investment is a good one. You may want to avoid investments with a
negative cash flow because you'll have to come up with additional money to
cover operating costs and debt payments.